At the conclusion of
annual Article IV bilateral discussions with the authorities, and prior
to the preparation of the staff's report to the Executive Board, the IMF mission often provides the authorities with a
statement of its preliminary findings.

Norway -- 1998 Article IV Consultation

Preliminary Conclusions of the Staff Mission
October 27, 1998

1. The Norwegian economy is at a crossroads. Norway’s economic
performance since 1993 has been among the best of any industrial country. There has been a
strong record of output growth, job creation, and improvement in real incomes, and the benefits
have been widely shared among social groups. The unemployment rate, at just over 3 percent of
the labor force, is one of the lowest in the world. Growth has been underpinned not only by high
and rising oil export revenues, but also by rapid expansion of the mainland economy.
However, the failure to moderate excess demand pressures has undermined the growth and
inflation outlook for the coming year and could weaken Norway’s longer-term economic
prospects. This note summarizes the strains that have emerged and steps that can be taken to
put Norway on a more sustainable growth path.

The Breakdown of the Existing Economic Strategy

2. Fiscal policy has been central to the success of Norway’s economic
strategy. The "Solidarity Alternative" strategy adopted in the early 1990's was
intended to preserve competitiveness of Norway’s mainland economy, and thereby help
ensure favorable growth and employment prospects both during and after the period of peak oil
production. Monetary policy was assigned the task of stabilizing the exchange rate of the krone,
over time, against European currencies. The social partners undertook to keep the rate of increase
in wages at or below the average in EU member countries. However, neither exchange rate policy
nor incomes policy could succeed unless fiscal policy played an active role in stabilizing the
economy. In the short run, fiscal policy could be used to help stimulate aggregate demand when
the economy was depressed but also had an obligation to reduce demand pressures when the
economy was operating near full capacity. From a longer run perspective, it was necessary for
public sector savings to be sufficient, during the period of oil-related external current account
surpluses, to avoid pressures for a real appreciation of the exchange rate and the resulting
deterioration of the non-oil current account
balance.1

3. Norway’s existing economic strategy has gradually become
inoperative. The breakdown began with fiscal policy, and subsequently spread to incomes and
exchangerate policy. Reflecting the rapid expansion of mainland GDP, output had returned
to levels consistent with full utilization of normal productive capacity by 1996, and since then
significant excess demand pressures have emerged. Nevertheless, fiscal policy, as measured by
the cyclically-adjusted, non-oil budget position of the central government, was close to being
neutral in 1997-1998.

4. While labor and employer groups are to be commended for their efforts to
moderate wage settlements in 1996-97, in the face of excess demand and tight labor markets,
these were not sufficient to maintain incomes policy discipline in the 1998 wage round. Average
wage increases are expected to be about 6 percent this year, some 2 percentage points above the
average rates of wage increase registered in the five preceding years. Wage settlements taking
effect during the last months of 1998 are particularly high, implying that the average rate of
increase in wages next year could well be in the range of 6-7 percent.

5. Against this background, the exchange rate of the krone has come under
significant downward pressure since early August and domestic interest rates have risen. In part,
the depreciation of the krone appeared to reflect market reactions to continued low prices for oil
and other primary commodities and a shift in portfolios toward assets in major money market
centers, as a result of turmoil in international markets. However, domestic developments,
including the high rate of wage settlements and uncertainty about the future course of
macroeconomic policy in Norway, may well have exacerbated the downward pressure on the
exchange rate. The government and Norges Bank have indicated that they consider the current
orientation of monetary instruments, including short-term interest rates, to be consistent with a
return of the exchange rate toward its previous trading range, once uncertainties about fiscal
policy are resolved.

The Coming Year Provides an Opportunity toPut Macroeconomic Policy on a Sounder Footing

6. Parliamentary consideration of the proposed National Budget for 1999 provides
an opportunity to forge a renewed consensus about the appropriate roles of fiscal, monetary, and
exchange rate policies. The IMF mission would like to offer the following reflections.

7. Recent exchange market and wage developments provide further evidence
of the need for a significant tightening of fiscal policy, both to address demand pressures and to
help restore a more appropriate long-run balance. IMF staff estimates suggest that the
positive output gap--the amount by which mainland real GDP exceeds its historical trend--is at
least 2½ percent this year. A fiscal contraction of about 1 percent of mainland GDP, as
reflected in the government’s budget proposal, should be viewed as the minimum
necessary to begin reining in excess demand. As discussed further below, one reason that neither
an exchange rate target nor an inflation target could be credible in the absence of fiscal discipline
is that excessive reliance on monetary policy to achieve the target can lead to lower growth than a
more balanced policy mix, tending to undermine the political basis for the policy.

8. While the first priorities are the size and timeliness of the fiscal adjustment, it
would be preferable for the reduction to come as much as possible through control of
expenditure, rather than revenue increases. This reflects two considerations. First, the tax
burden in Norway is already high by international standards. Increasing already high rates of
taxation would tend to undermine Norway’s international competitiveness. Second,
the analysis of long-term prospects in connection with the budget proposal demonstrates that,
while it should be feasible to accumulate balances in the State Petroleum Fund that are sufficient
to enable the government to meet its future pension liabilities, this will require holding public
employment and expenditure to rates of increase in the coming decades that are well below the
actual increases experienced in the recent past. Over the past two years the potential imbalance
has actually become larger, as a result of changes in early retirement schemes and pension
entitlements that would raise pension obligations over the long run by about 2 percent of GDP.
Norway should not lose the opportunity to use its oil wealth to put fiscal policy on a sound
long-term footing.

9. With regard to monetary and exchange rate policy, it is clear that a nominal
anchor can help to guide wage and price expectations and safeguard competitiveness in a small,
open economy. For that reason, the debate about monetary policy in Norway has generally
focused on the choice between two relatively transparent nominal anchors, an exchange rate
target or an inflation target. For the near term, we would make the same policy prescription under
either of these alternative monetary frameworks: interest rates should not be reduced until there
are clear prospects for a reduction of wage and inflationary pressures. It is important to bear in
mind that the existing, large interest rate differential with EMU currencies could be interpreted in
part as a reflection of concern that there may be a further deterioration in Norwegian
competitiveness in the coming year. Agreement on an appropriate budget for 1999 would be a
crucial step toward addressing this concern.

10. A major intermediate objective of Norwegian economic policy in the
coming year must be to moderate the increase in wages. While this is unlikely to be possible
without a strengthening of fiscal policy, it will also be important for the social partners to
maximize their own contribution to the process. It would be extremely desirable to restore the
consensual, growth-oriented approach to economic policy followed in recent years. If, however,
this effort is not fully successful, further high wage settlements in 1999 would need to be met by
determined application of all available policy instruments, including further increases in interest
rates, to contain the damage and help prevent a recurrence.

The Choice of a Nominal Anchor

11. As indicated above, the near-term prescription for monetary policy does not
depend on the choice of monetary framework. However, economic developments may eventually
lead to a more decisive examination of this topic. The choice of monetary framework is
not an abstract, theoretical matter--it must be grounded in the specific situation facing Norway. It
is difficult for Norway to pursue an exchange rate target, given its vulnerability to large
terms-of-trade shocks and the impending completion of the third stage of European Monetary
Union. Under these circumstances, there may be merit in considering a shift to an inflation
targeting framework, provided that there is acceptance of the need for continued fiscal discipline
and a willingness to provide Norges Bank with greater operational independence. The remainder
of this section elaborates on some considerations in the choice of a nominal anchor.

12. First, recent experience underscores the importance of fiscal policy for
price and exchange rate stability, no matter which monetary framework is chosen. Thus, the
choice between exchange rate and inflation targeting should not be misconstrued as a choice
between the presence or absence of fiscal discipline. While it might be possible to achieve an
inflation target for a time despite an excessive non-oil fiscal deficit, this would come at the cost
of higher than necessary interest rates. This could have profound effects on growth performance
that would tend to undermine the political acceptability (and hence, the credibility) of the
policy.

13. Second, the impending completion of the third stage of European
Monetary Union could have a major influence on exchange market dynamics in Norway. As
a country with strong economic and financial ties to the Euro area but not participating in EMU,
Norway can expect to experience a higher degree of exchange rate volatility in the immediate
future. This will make it more difficult to pursue an exchange rate target. In principle, the
constraint could be overcome through a formal association with the EMU but such a decision is
not, in any event, up to Norway alone. While countries that are unsure of their ability to target the
exchange rate narrowly have at times tried to address this problem by setting the exchange rate
objective within a broad or ambiguously-defined range, such an approach is unlikely to provide a
clear or credible anchor for wage and price expectations.

14. Third, since exchange rate changes have a major effect on costs and prices
in Norway, they would need to be taken into account as an important indicator of the appropriate
stance of monetary policy, under an inflation targeting framework.2 Under an inflation targeting framework the authorities
would need to assess carefully any significant depreciation of the nominal exchange rate. Under a
variety of circumstances it might be appropriate to resist depreciation; however, the situation
could be more complex if the depreciation was interpreted as a response to a real shock, such as a
change in the terms of trade. In that case it might well be appropriate to accommodate the initial
depreciation of the exchange rate, but to use monetary and fiscal policy to resist any
second-round effects on wage and price performance.

15. Finally, exchange rate and inflation targeting may have different
implications for the operational independence of the central bank. In most countries that
have adopted inflation targeting, this was accompanied by arrangements under which the goal of
monetary policy is established by law, but the central bank is given independence in using its
available instruments to pursue that goal. The central bank is required to provide complete and
timely information about its activities and is strictly accountable for the results. In Norway this
would require the replacement of the current monetary policy regulation by a decision adopting
(and defining quantitatively) the goal of price stability. In addition, it would appear necessary for
any shift to inflation targeting to be accompanied by arrangements to increase the operational
independence of Norges Bank. Interest rate policy is carried out by Norges Bank, but the King in
Council retains the ability to overturn Norges Bank’s decision. While this possibility has
never been used, its continued existence would tend to undermine the credibility of the inflation
target.

Structural Issues in the Context of European Monetary Union

16. The completion of the third stage of EMU will bring benefits to all European
countries, through lower costs and prices and higher factor mobility. In addition, countries
that are not participating in EMU may find themselves at a competitive disadvantage. Under
these circumstances it will be doubly important for Norway to adapt structural policies to avoid
unnecessary costs and inefficiencies. The banking sector is a case in point. The practices of
the Kredittilsynet and other supervisory authorities have continued to evolve in order to
discourage excessive risk-taking and promote the stability of the Norwegian financial system.
Nevertheless, in the coming years the banks should be prepared to increase loan loss provisions,
in response to a weaker global economic environment, low commodity prices, and slower growth
in Norway itself. In addition, there would appear to be a growing case for liberalizing restrictions
on bank mergers, as trends in European banking markets (including those in other Scandinavian
countries) suggest that further consolidation will be required to maintain profitability. In a similar
vein, the degree of government support to the agricultural sector in Norway is one of the highest
among advanced economies, exceeded only by Japan and Switzerland, and imposes a deadweight
loss to the economy far in excess of benefits to farmers. It is important for Norway to begin
dismantling this regime as soon as possible, in its own national interest and in solidarity with
international efforts to increase access by developing countries to world agricultural markets.

17. The IMF staff would like to commend the government and people of Norway
for their commitment to overseas development assistance.

1By running fiscal surpluses during the period of peak oil
production, the government was able to begin saving much of Norway's oil export earnings in
the State Petroleum Fund (SPF). The accumulation of large balances in the SPF during the period
of high oil production provides resources to help the public sector to meet future pension and
health care obligations to the current working population, as these obligations rise in line with
demographic trends.2Since imported goods account for about 40 percent of the
basket of goods in the consumer price index, an exchange rate depreciation of 5 percent could be
expected to result in an increase of about 2 percentage points in the CPI, with the full effect
becoming evident within about 1½–2 years.